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Nasdaq's New World of Orders : Reforms Begun Last Year Have Saved Investors Billions as Dealer Markups Have Narrowed

NEW YORK — Reforms adopted a year ago at the Nasdaq Stock Market have helped ordinary investors crack what used to be a members-only club.

Buy and sell orders from plain folks--many of them, to be sure, wielding personal computers and Internet trading accounts--now have the power to directly determine Nasdaq stock prices in ways that only member broker-dealers could in the past.

The new order-handling rules "forced competition upon a reluctant group of market makers, and it's been a stunning success," said David K. Whitcomb, a Rutgers University finance professor and sometime Nasdaq critic.

Others are less ebullient about the changes. Nonetheless, the result of the reforms--plus Nasdaq's move last June, with other U.S. markets, to start quoting share prices in minimum increments of sixteenths of a dollar (6.25 cents) instead of eighths--has been a sharp decline in dealer "spreads," or stock price markups, and investor savings estimated in the billions of dollars.

The National Assn. of Securities Dealers, Nasdaq's parent organization, says average spreads between stock "bid" and "asked" prices have shrunk 41% since the implementation of the new order-handling rules. The rules were phased in beginning in January 1997 and extended to all 5,500 Nasdaq stocks by October.

Some experts contend that because of a quirk of measurement, the true drop in spreads might be only about half the stated 41%. But either way it has been a boon for investors.

San Francisco-based discount brokerage giant Charles Schwab Corp. provided dramatic evidence of the impact of shrinking spreads in its first-quarter earnings report: Schwab's earnings rose just 2% from a year earlier, hurt in part by a 24% decline in trading revenue from the firm's New York-based Mayer & Schweitzer unit, a major Nasdaq market maker.

"The entire first quarter of 1998 reflected the dramatic changes in Nasdaq trading rules that were phased in during 1997," Schwab said in a statement.

And so far at least, there is little evidence of the feared downside of shrinking spreads: that dealers' falling profitability would drive a large number of them out of market-making activities, hurting investors' ability to buy and sell Nasdaq stocks when they want and in the quantities they want.

Still, except for last October's brief market turbulence, there hasn't yet been a stern test of the Nasdaq market's liquidity under the new trading rules.

The reforms were imposed by the Securities and Exchange Commission after years of criticism of Nasdaq, and after the SEC in 1996 found that Nasdaq market makers had been illegally colluding to maintain wide spreads and keep investors from getting in between those spreads.

Say, for example, that a market maker is quoting a bid (buy) price of $40 and an asked (sell) price of $40.25 for a particular stock, and that an investor places a "limit" order--an order stating a specific price--to buy at $40.06.

Before the reforms, market makers could in effect ignore limit orders that would cut into their spread. Now, under the new order-handling rules, dealers must either promptly meet and execute such "inside" orders or electronically display them to the whole market, so other investors have the chance to trade at the inside price.

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The competition that this move instilled was turbocharged by Nasdaq's decision to also display any inside orders that enter the market through the fast-growing private electronic communications networks, or ECNs, such as Reuters' Instinet, Island and Bloomberg Tradebook, through which professional traders and big institutions trade directly with each other rather than with dealers.

Although the principal customers of the ECNs are institutions, Internet brokerages such as E-Trade also use ECNs. That means that limit orders from individual investors trading from their home personal computers can set the tone for prices in the Nasdaq market overall.

As the ECNs' share of Nasdaq trading volume continues to rise, it's estimated that customer orders, rather than dealer-generated quotes, now are dictating the prices of Nasdaq stocks at least 20% of the time. And given that dealers have had to shrink their spreads to remain competitive, the real price effect of the ECNs and limit orders is magnified.

Patrick Healy, a former Nasdaq official who now is president of Chevy Chase, Md.-based Issuer Net, which advises companies on where to list their stocks, said that 20% figure represents a big step forward for Nasdaq in its evolution from a purely dealer-driven market to more of an order-driven--or auction--market like the New York Stock Exchange.

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The SEC had hoped that the order-handling reforms would encourage more use of limit orders by individual investors, thereby enhancing competition and narrowing spreads. Has it happened?

Odd as it may seem, Nasdaq says it currently has no mechanism for measuring the flow of limit orders, as distinct from market orders, which do not specify a price.